Saturday, 27 June 2020

Classic VAT DoubleThink

The myth is that VAT is a relatively benign tax because it is a "tax on consumption". Anybody who knows anything about tax incidence and bothers to look at actual statistics on what happens to prices, output levels and profits or wages when VAT rates change; or price differences in the USA where each state has different Sales Taxes knows that this is nonsense.

Value Added Tax is the worst of both worlds, it acts like a tariff, so dampens economic activity and is also, quite literally a tax on "value added" i.e. wages and earned profits. It's a crude profits tax that is payable even if a business isn't actually profitable (but would be if there were no VAT).

In the UK, businesses pay about three times as much VAT as they do corporation tax, so surely, if you interested in the tax system, you focus on VAT. But all the attention is directed at corporation tax. There are loads of headlines that Starbucks or Apple (or whoever) pay little or no corporation tax in the UK, which is quite probably true. But they still hand over £ billions in VAT.

So far so bad.
Mombers spotted this at Bloomberg:

There’s a new bad idea doing the rounds in Europe. Many governments are convinced that a reduction in value-added tax will help relaunch their economies. Some, including Germany, have already wielded the ax. Others, such as Italy and the U.K., are taking this option seriously.

But the benefits of cutting VAT are limited, and the costs are large.

Reducing VAT from 20% to 17.5% was the best thing that Alastair Darling could have done back in 2009. He did it and it worked i.e. softened the impact of the financial recession. The benefit was measurable and large and far from 'limited'.

As with any other tax cut, the key question is who gains from it. The answer for VAT depends on a concept economists call “incidence,” which refers to how the tax burden or benefit is shared between companies and consumers. In the case of VAT, retailers can either pass on any reduction to shoppers by lowering their prices or they can keep their prices unchanged and pocket the difference.

Unfortunately, research shows they’re more likely to do the the latter, which wouldn’t be much use for any policymaker looking to use such cuts as a way of fostering a consumer-led recovery... They looked at a large cut (from 19.6% to 5.5%) for sit-down restaurants in France in 2009, after the financial crisis.

The results showed that consumers weren’t the chief beneficiaries of the reduction. It was the restaurant owners. The price of a restaurant meal decreased by a mere 1.4% in the month after the steep VAT cut, and it didn’t fall much further over the next two and a half years. The two researchers showed that restaurant owners pocketed 41% of the economic gain from the VAT reduction, while consumers got 19%. Restaurant staff obtained 25% in the form of higher wages, and suppliers accounted for the rest.

This is of course exactly what you'd expect to happen (it has been observed countless times). There was plenty of evidence ten years ago that this is what happened, it is hardly a new insight. What they don't mention is that output increased (a lot more people visited restaurants, even though prices had only dropped a bit).

So, having made the false assumption that VAT is a benign tax because consumers pay it, they argue that VAT cuts are bad because consumers don't pay it? The article then goes on to say that VAT increases are bad because consumers do pay it! Do they not realise that they are contradicting themselves at least twice over? Is there such a thing as TrebleThink? Everybody's entitled to be wrong, but at least be consistent!

As to "fostering a consumer-led recovery", people can't consume more unless somebody else is producing more. And do they not realise that restaurant owners, restaurant staff and restaurant suppliers (and their employees) are all consumers too? If they have more money to spend, they will probably spend it.


Rich Tee said...

The fact that a country has to levy VAT as a condition of EU membership reminds me of the initiation ceremony a person must perform before they are allowed to be a member of a gang.

Or payment to a protection racket. (The EU a protection racket? Heaven forbid!)

Mark Wadsworth said...

RT, but why did they choose such a shit tax? Either it was an innocent mistake they are too embarrassed to admit, or they are just corporatists/mercantilists. I suspect the latter.

Andrew Carey said...

Imagine you had a binary choice - reduce CT to zero, or reduce VAT from 20% to 15%. Both changes resulting in the same loss of income to the Exchequer in the 1st year of the change.
You would go with the CT change - optimal tax theory and all that.
That there are people with STEM degrees who would prefer the VAT cut is a cause for despair. We truely are heading for disaster.

Bayard said...

"You would go with the CT change"

Why? Everyone pays VAT. You have to make a profit before you pay CT.

ThomasBHall said...

@Andrew Carey- why? Mark explains why VAT is the worst tax possible above. Anything to lower it is good. It literally blocks thousands of businesses from existing, and they don't have a profitability greater than 20%. It is a domestic tariff of 20% for Pete's sake!

Mark Wadsworth said...

AC, I would reduce vat of course. If "optimal tax theory" says cut CT, it was invented by idiots.

B, TBH, ta for back up.

Physiocrat said...

VAT produces, net to the exchequer, not much more than a third of the headline figure. Scrapping it may well result in no loss at all.

Here's why

These are back-of-envelope calculations which need more work.

The incidence of VAT is partly on the retailer and partly on the customer ie some of the tax cut would be passed on. The real point is that VAT can push businesses below the margin. The real mischief of VAT is that it exerts a tariff barrier at the exact point where supply meets demand. That is a bad as any tax can be. It maximises the deadweight loss. A 1% cut in VAT is worth at least 0.25% GDP growth.

Physiocrat said...

Why did the EU choose such a terrible tax when it did not have to? It may be because the architects of the EEC's economic policies were influenced by Catholic Social Teaching which was influenced by Thomas Aquinas (the theory of the just wage, etc). They had obviously never heard of Ricardo or the Physiocrats - the latter were of no account as they were part of the old monarchist France.

Catholic Social Teaching is a disaster area in its own right, which began as an attempt to knock down the ideas in Progress and Poverty which had gained force when Rerum Novarum was given out in 1891.

Mark Wadsworth said...

P, VAT pushes us to the top of the Laffer Curve, but I don't think it pushes us past it.

Physiocrat said...

VAT costs and losses
1) Admin - not very much as the costs are transferred to business.
2) Churning - VAT is part of the price index to which pensions, benefits and public sector pay are linked. This makes it a major government cost in its own right.
3) Abstraction from other taxable revenue streams.
4) Welfare costs arising from deadweight losses.
5) Tax revenue losses due to deadweight losses (separate from abstraction).

My piece on the LVTC web site needs to be re-worked with better calculations. I would not be surprised if, because of the above, the Exchequer is out of pocket due to VAT.

Mark Wadsworth said...


don't underestimate 1) admin costs, they are huge, just as much as for PAYE (compliance costs for corp tax are +/- nothing in comparison).

2) to 5) agreed. My estimate is that getting rid of VAT £130 billion-odd means that other tax receipts (PAYE etc) go up and welfare payments go down. So net revenue loss probably only half of £130 billion = £65 billion, which could be raised with a 0.9% annual property tax (or a 25% LVT on site premiums). Everybody wins!

Derek said...

Optimal tax theory says that we should tax the goods in the most inelastic supply (or demand) first. Unsurprisingly the good in most inelastic supply is land.

So Optimal tax theory basically says "Tax land".

Mark Wadsworth said...

D, yes of course.

And VAT is at the other end of the scale. It taxes the things with the most elastic demand (and fairly elastic supply).

mombers said...

"The two researchers showed that restaurant owners pocketed 41% of the economic gain from the VAT reduction"
Imagine how awesome this is for a marginal business that could go under at any minute!! The number of marginal businesses has increased enormously under lockdown so a huge win if all of these can be allowed to continue trading if VAT is reduced

Mark Wadsworth said...


a) exactly

b) the use of the word 'pocketed' implies dishonesty, doesn't it? That's how biased the article is.

Dinero said...

Why did the EU choose it ?
Well there is a kind of EU logic to it. The EU started off as the single market , a new set of transactions adding to the exchequers in different countries from people from other countries, and so there is a synergy to it. Also a more practical reason , with VAT in place the origin and destination of goods across the EU is tracked by the VAT system without customs. Pure guess.

Mark Wadsworth said...

Din, fair points, probably one of the reasons.

Physiocrat said...

@Dinero - the EEC could have achieved the same effect by prohibiting member countries from levying taxes on goods and services - perhaps with exceptions such as booze and fags.

The origin and destination of goods was and is none of any government's business and they should keep their snouts out of transactions between private individuals. This is information which should not even be collected by governments. It inevitably leads to misguided interventions which normally have the opposite effect to that intended.

Dinero said...

It occurs to me that VAT has a monopoly profit tax element to it. In that it taxes the profit margin on a transaction rather than the profit of the balance sheet aggregate turnover. Not that , that , has a practical consequence.

Mark Wadsworth said...

Din, in reality, VAT is the opposite of that. That's why big/monopoly companies prefer VAT to corporation tax. VAT crushes the lower-margin competition. The lower margin competition, having lower or no profits, prefer corporation tax to VAT.

Also, turnover doesn't appear on the balance sheet, it goes in the profit and loss account.

Dinero said...

> Mark
I was thinking of the word monopoly in that where a vendor sells something unique and in demand , without competition then that vendor can successfully pursue a high profit margin.

Physiocrat said...

You can see roughly what happens in duty-free zones eg airport shopping malls. A bit of the VAT concession is passed on in lower prices and the rest is taken in higher profits. From there it is taken in higher rents and higher rateable values. My guess is that the net loss to the exchequer from an airport shopping mall is around zero.

Mark Wadsworth said...

Ph, it's stupider than that. The govt 'punishes' flyers with Air Passenger Duty and 'rewards' them with Duty Free.